The 5 Essential Financial Accounts You Need and How Much to Contribute to Each
Alright, so let’s get a *DISCLOSURE* out first. These 5 Essential Accounts are the five accounts I find essential for me! This is purely my opinion but I do think it can apply fairly well for most people from my studies and research into how to develop and implement good personal finance strategies and it may be one you would like to implement. This is Only a Strategy meaning, that it may not be the right strategy for you based on your risk tolerance, age, personal financial goals and so on. If you’re not sure it will be right for you, then you should speak with a certified financial professional to help determine the best plan for you.
Now that that’s been said, we’re going to talk about 5 Types of Financial Accounts which can help you in any financial strategy. Even if the specific account types don’t apply to you or you’re not eligible for that type, understanding these accounts can still be valuable if your financial position or goals change in the future. I’ll also explain how you can strategize contributions to these accounts in a medium to low risk way that can help you better reach your different financial goals. So let’s get into it!
1) Checking Account
You may already have one, but a Checking Account is literally defined as “a bank deposit against which checks can be drawn by the depositor” from our friends at Dictionary.com. However, that really doesn’t do this account justice especially since most people rarely use checks anymore. The real value of a checking account is that it allows you to easily transfer funds into and out of the account for daily transactions. The real focus there is “daily transactions”. These accounts have fewer or no limitations on how often or how much you can deposit or withdraw making them ideal for regular transactions. This makes them great for short term to immediate spending such as paying bills or buying things.
These accounts also typically have included Debit Cards making them convenient for transactions. In case you aren’t aware, a Debit Card looks and operates like a Credit Card but is connected to an account. So when you make a purchase with a debit card, it will automatically transfer that money out of your checking account to pay the seller you are purchasing from. Credit cards on the other hand, essentially offer you a loan for purchase price and pay the seller with that, expecting you to pay them back. The big difference; Debit Cards only allow you to spend up to what is in your account while Credit Cards let you spend money you may not have.
One downside to Checking Accounts, is that they tend to offer very low to no interest return. When you put your money in a bank account, the bank will use the money you aren’t using to make loans and such to other people until you need your money back. For being able to do this, they will pay you interest as a percentage of your account. Since checking accounts are so great for daily transactions, the funds in them aren’t as helpful for the bank to make loans and that’s one reason interest rates are low. We’ll talk more about the interest rates and how to use checking accounts more in the “How Much to Contribute to Each” section at the end of this post.
2) Emergency Fund
Now, an Emergency Fund is an account saved for an exceptional financial crisis to serve as a Safety Net. However, don’t think of it as your “Rainy Day” fund, but more as your “Tropical storm, Hurricane is on the Way” Fund. By this, I mean this is an account where you have funds set aside for serious emergencies, like losing your job or an expensive repair. Because of this, experts generally recommend putting away 3 to 6 months worth of Expenses into these accounts although you may want more or less depending on your situation and not touching it. We’ll talk more about that in the “How Much to Contribute to Each” section, so stick with me.
Also, an Emergency Fund isn’t an account like a checking account. It can be any account you prefer with the purpose of saving for Emergencies. One important factor you’ll want for this type of account is high liquidity. By that I mean, you want to be able to access it quickly if you need it. Because of this, you may want to consider a High Yield Savings Account.
High Yield Savings Accounts (HYSA) are a similar to checking or other savings accounts except that they tend to yield significantly higher interest rates of return (hence the name). Checking accounts Average 0.03% annual return according to FDIC, if your lucky enough to get interest at all. So if you had $10,000 in this account, you would only make $3 in Interest. Typical Savings accounts are almost just as low. The National Average Interest Rate for Savings is 0.17% Annual per year per FDIC. So that $10,000 would yield only $17. That’s not much better. Now a High Yield Savings Account may offer Interest Rates 2% to 3% currently. For an example, Ally Bank (*Not sponsored. Just like the Bank!) offer 2.25% Annual Percentage Yield. That means that $10,000 would now yield $225! It goes without saying, that is a LOT more!
The only downside is you are limited to only 6 withdrawals per month by Federal Law. Because of that, you obviously couldn’t use one for every day purchases which is where a checking account comes in. However, this makes it Great for an Emergency Fund! You can still Access the Funds Immediately if needed, as long as you have less than six emergencies per month (fingers crossed), and that money will Grow Faster than in checking or another savings account. In fact, if the Federal Reserve can reach and maintain it’s goal of keeping inflation below 2%, a High Yield Savings Account could keep up with Inflation.
3) Retirement Account(s)
A Retirement Account is a financial account especially set aside for the purpose of living off of after you stop working. There are many different types out there, but we’ll focus on two main types; a 401(k) Account and an Individual Retirement Account (IRA). Now, both of these accounts are Tax-Advantaged Accounts meaning that you either don’t pay taxes on contributions (Traditional) or you won’t pay taxes on withdrawals (Roth). There are Traditional and Roth options for both accounts. They also serve as Investment Accounts where you can buy different securities such as stocks, bonds, and mutual funds. This allows your money to grow significantly faster with the other tax advantaged benefits mentioned before. These accounts do have limitations on how much you can contribute and both have a penalty if you withdraw earnings before 59 1/2 years of age which is why we consider them Retirement Accounts. Beyond that, there are two main difference between a 401(k) and an IRA;
1) A 401(k) is Employer Sponsored while an IRA is Self Managed
2) The 401(k) Contribution Limit is $20,500 per year for 2022 and the IRA Contribution Limit is $6,000 per year
Since a 401(k) is Employer Sponsored, your Employer might offer Contribution Matching of a specific percentage. An IRA obviously doesn’t have that. This will be important to consider when determining “How Much to Contribute to Each” which we’ll get into at the end of the post. If you want to learn more about 401(k)s or IRAs, just click the links for a related post.
4) Short Term High Yield Savings Account
Short Term High Yield Savings Account (HYSA) is exactly how the title has it. It’s a High Yield Savings Account for Short Term Goals. This is a savings account for purchases you plan to make soon while also gaining the benefits of liquidity and higher earnings. Now, I won’t define Short term for you. It can be however long you want it to be from a purchase within the next few months to the next few years. Generally though, I personally use these savings accounts for purchases no further than 5 years away.
Now, this account is designed to serve two purposes; a place to Save for “Big Purchases” and a place to Earn More on “Soon Needed” Funds. I’ll start with the first purpose of Save for “Big Purchases”. If you’re planning on buying a house or going on a big trip or maybe even getting married, this is where you save for those goals. That way, you can put money aside every month or every paycheck towards those goals. But why do you need an HYSA for that? Three Reasons;
1) If you leave the money in your Checking Account, you may accidentally spend it.
2) The savings will grow more in an HYSA than in Checking.
3) It helps you enjoy the process of saving and anticipating a purchase.
Now, I want to explain the third reason a bit more. Technically, you don’t need an HYSA for this, but having a separate savings for your goals will allow you to watch those savings grow in separately which is part of the fun! I don’t know about you, but part of the fun of a big purchase for me is the anticipation. For a big trip for example, anticipating the adventure and researching where I’m going is almost as fun as the trip itself. Part of that anticipation is saving for that trip. Because of that, I have a special savings account designated for “Travel Savings” and by having that savings in a separate location, it increases my anticipation for the trip and lowers my anxiety about knowing I can afford it. It’s a win win!
Also, some HYSAs offer special features to make saving for goals easier. To talk about Ally Bank again, they offer “Buckets” to help organize your savings. Instead of opening a bunch of different accounts, you can create a “Bucket” for a specific Goal and have the money put in that “Bucket”. It’s still in the same account, but just categorized differently. You can even set goal amounts and dates for each “Bucket”. So if you made a Vacation “Bucket”, and you know that week long trip to Cabo you’ve been dreaming of will cost $4,000 total, you can set the “Bucket” goal to $4,000 and for the date you want to travel on.
We’ll break down the second purpose in the “How Much to Contribute Each” section.
5) Individual Brokerage Account
Finally, we have an Individual Brokerage Account which is an investment account that allows you to buy and sell securities such as stocks, bonds and ETFs. Sounds like a Retirement Account, right? Well, the big difference is these accounts are NOT Tax-Advantaged, meaning that if you sell a stock or earn a dividend from that stock, you will have to pay taxes on it. Now you may end up paying Income Tax or Capital Gains Tax depending on when you sell or the type of dividend earned, but you can learn more about that by clicking the links.
How Much to Contribute to Each
To disclose once more, this is just my strategy that I like follow with how I contribute to each account. Your financial situation may be different, but this is what I like to do and it works for me and it may also work for you. Most importantly having a strategy simplifies what I do with my money and gives it a job to make more money while I sleep. If you’re strategy allows you to grow your net worth, even when you aren’t actively working, that’s the way to go!
I’ve listed the accounts below in the order I contribute and with how much I contribute. If you are able to replicate this flow, you would be following the same method I am.
1) Checking Accounts - Minimum for Paying Bills + “Cushion”
For my checking account, I use it as a Funds Funnel. What I mean is, my job direct deposits my paycheck into my checking account. I then use that to pay off the entire balance of all my credit cards and to pay whichever bills are charged that pay period. I then try to leave a $500 “Cushion” in the account. This is incase I need to withdraw some cash at an ATM or have a cheaper bill to pay off between pay periods. It also just makes me feel comfortable to know there is some money in my checking. After that, I will use the remaining funds to make the following contributions. After all that, the “Big Take-Away” I hope you get from this is you want to leave as Little Money in your Checking as Possible! If it’s not earning money for you while you sleep, the money doesn’t have a job and could be used better elsewhere.
2) Emergency Fund - 6 Months of Expenses
The goal here is to put away 3 to 6 months worth of Expenses as we mentioned above. Although my job is very secure, I’m married with a newborn, so I chose to keep 6 months of expenses. You may choose more or less depending on your situation. For an example, as we approach retirement, my wife and I will increase our Emergency Fund to 12 Months of Expenses. This is to reduce the need to sell any securities during a recession. Right now, my wife and I Already have 6 Months of Expenses Saved, and because of that, we are Not Currently Contributing to our Emergency Fund. If you choose to follow this strategy too, once your Emergency Fund reaches your Goal Amount, you can also Pause Contributions.
3) Retirement Account - 401(k) Match > Max IRA > Max 401(k)
Now this will be a bit more confusing based on your personal situation. For example, if you’re self employed or your employer doesn’t offer a 401(k), you may not be eligible to contribute to a 401(k). However, if you are eligible, this is the order I follow;
1) Up To Employer’s 401(k) Match - If your employer offers 401(k) matching, you are Losing Out on Free Money if you don’t at least contribute the 401(k) Match. That should be your MINIMUM FIRST STEP if it is offered
2) Max Out IRA - Next, contribute as much as you can into an IRA up to the Max of $6,000 per year. The reason for an IRA first over a 401(k) is because you have more flexibility with an IRA and are therefore likely to make a higher return.
3) Max Out Remaining 401(k) - So you’ve met the matching for your 401(k) and Maxed Out your IRA, now is the time to up your 401(k) Contributions. If you are able to reach the max of $20,500 a year, Go For It! Because of the Tax Advantages, this will give you the best return on your investment
Now, whether your Employer offer 401(k) or not, Anyone In the US Earning Regular Income can Contribute to an IRA! Whether your 14 or 40 years old, if you can afford to do it, Open an IRA! You can even do so Right Now with these links to WeBull or E*Trade! Thanks to Compound Interest and Time in the Market, the Longer you’re Invested, the More Money you will Make! (Of course, Past Performance does not guarantee future performance, all Investments have risk, etc, etc, etc)
4) Short Term HYSA - Goal Target Amounts + Extra Needed
So, we already talked long about creating Goals for Short Term Big Purchases but we haven’t yet discussed the “second purpose”. The second purpose was to Earn More on “Soon-Needed” Funds. Basically, you don’t want to leave money in your checking account because it will not gain the same return as in an HYSA. However, if you have an expensive bill or something coming up such as “routine car maintenance”, you won’t want to invest that money either. So, what you can do is put that money in your Short Term HYSA. That way, it earns a higher yield and you can access it when the funds are needed.
So, for the total contribution to your Short Term HYSA, you’ll contribute your Short Term Goal Amounts and Any Extra Needed Soon.
5) Individual Brokerage Account - Anything Left
So let’s be a bit blunt here, this account isn’t truly essential. You Don’t Need an Brokerage Account if you Can’t Max Out All Previous Contributions! Also, you will also likely retire more than comfortably if you have a solid Emergency Fund just max out Retirement Accounts. That being said, if your Goal is to Retire Early or you Have Extra Funds with No Job, then you should have an Individual Brokerage Account. If you meet all those criteria and want to open an Individual Brokerage, you can do so right now with these links for WeBull or E*Trade Now!
Links
If you’re interested in opening an IRA with E*Trade, click this link (→E*Trade←) and you will get rewarded with up to $3,500 once you open an account and make a qualifying deposit! Reward amount depends on how much you deposit.
If you’re interested in opening an IRA with WeBull, click this link (→WeBull←) and you can earn up to 5 free stocks when you open and fund your account
*Disclosure* This is NOT financial advice and I am NOT a Certified Financial Planner. All information is provided for educational purposes only and is not to be construed as advice. Everyone’s financial situation is different and requires individualized planning. Seek out a Certified Financial Planner for assistance with your own financial situation.
*Affiliate Disclosure* This post contains an affiliate link. By clicking on the link and utilizing the service, LiveItAwesome LLC and/or the posts author may receive some form of compensation from the linked Affiliate.
